CHAPTER 9

INCOME AND SPENDING

Solutions to the Problems in the Textbook:

Conceptual Problems:

1. In the Keynesian model, the price level is assumed to be fixed, that is, the AS-curve is horizontal
and the level of output is determined solely by aggregate demand. The classical model, on the other
hand, assumes that prices always fully adjust to maintain a full-employment level of output, that
is, the AS-curve is vertical. Since the model of income determination in this chapter assumes that the
price level is fixed, it is a Keynesian model.

2. An autonomous variable’s value is determined outside of a given model. In this chapter the following
components of aggregate demand have been specified as being autonomous: autonomous
consumption (C*) autonomous investment (Io), government purchases (Go), lump sum taxes (TAo),
transfer payments (TRo), and net exports (NXo).

3. Since it often takes a long time for policy makers to agree on a specific fiscal policy measure, it is
quite possible that economic conditions may drastically change before a fiscal policy measure is
implemented. In these circumstances a policy measure can actually be destabilizing. Maybe the
economy has already begun to move out of a recession before policy makers have agreed to
implement a tax cut. If the tax cut is enacted at a time when the economy is already beginning to
experience strong growth, inflationary pressure can be created.
While such internal lags are absent with automatic stabilizers (income taxes, unemployment
benefits, welfare), these automatic stabilizers are not sufficient to replace active fiscal policy
when the economy enters a deep recession.

4. Income taxes, unemployment benefits, and the welfare system are often called automatic stabilizers
since they automatically reduce the amount by which output changes as a result of a change in
aggregate demand. These stabilizers are a part of the economic mechanism and therefore work
without any case-by-case government intervention. For example, when output declines and
unemployment increases, there may be an increase in the number of people who fall below the
poverty line. If we had no welfare system or unemployment benefits, then consumption would drop
significantly. But since unemployed workers get unemployment compensation and people living in
poverty are eligible for welfare payments, consumption will not decrease as much. Therefore,
aggregate demand may not be reduced by as much as it would have without these automatic
stabilizers.

5. The full-employment budget surplus is the budget surplus that would exist if the economy were at the
full-employment level of output, given the current spending or tax structure. Since the size of the
full-employment budget surplus does not depend on the position in the business cycle and only

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 changes when the government implements a fiscal policy change, the full-employment budget surplus
can be used as a measure of fiscal policy. Other names for the full-employment budget surplus are the
structural budget surplus, the cyclically adjusted surplus, the high-employment surplus, and
the standardized employment surplus. These names may be preferable, since they do not suggest
that there is a specific full-employment level of output that we were unable to maintain.

Technical Problems:

1.a. AD = C + I = 100 + (0.8)Y + 50 = 150 + (0.8)Y

The equilibrium condition is Y = AD ==>

Y = 150 + (0.8)Y ==> (0.2)Y = 150 ==> Y = 5*150 = 750.

1.b. Since TA = TR = 0, it follows that S = YD - C = Y - C. Therefore

S = Y - [100 + (0.8)Y] = - 100 + (0.2)Y ==> S = - 100 + (0.2)750 = - 100 + 150 = 50.

1.c. If the level of output is Y = 800, then AD = 150 + (0.8)800 = 150 + 640 = 790.

Therefore the amount of involuntary inventory accumulation is UI = Y - AD = 800 - 790 = 10.

1.d. AD' = C + I' = 100 + (0.8)Y + 100 = 200 + (0.8)Y

From Y = AD' ==> Y = 200 + (0.8)Y ==> (0.2)Y = 200 ==> Y = 5*200 = 1,000

Note: This result can also be achieved by using the multiplier formula:
∆Y = (multiplier)(∆Sp) = (multiplier)(∆I) ==> ∆Y = 5*50 = 250,

that is, output increases from Yo = 750 to Y1 = 1,000.

1.e. From 1.a. and 1.d. we can see that the multiplier is 5.

1.f. Sp Y = Sp
AD1 = 200 = (0.8)Y

ADo = 150 + (0.8)Y

200

150

0
750 1,000 Y

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2.a. Since the mpc has increased from 0.8 to 0.9, the size of the multiplier is now larger and we should
therefore expect a higher equilibrium income level than in 1.a.

AD = C + I = 100 + (0.9)Y + 50 = 150 + (0.9)Y ==>

Y = AD ==> Y = 150 + (0.9)Y ==> (0.1)Y = 150 ==> Y = 10*150 = 1,500.

2.b. From ∆Y = (multiplier)(∆I) = 10*50 = 500 ==> Y1 = Yo + ∆Y = 1,500 + 500 = 2,000.

2.c. Since the size of the multiplier has doubled from 5 to 10, the change in output (Y) that results from a
change in investment (I) now has also doubled from 250 to 500.

2.d. Sp Y = Sp
AD1 = 200 = (0.9)Y

ADo = 150 + (0.9)Y

200

150

0
1,500 2,000 Y
3.a. AD = C + I + G + NX = 50 + (0.8)YD + 70 + 200 = 320 + (0.8)[Y - (0.2)Y + 100]

= 400 + (0.8)(0.8)Y = 400 + (0.64)Y

From Y = AD ==> Y = 400 + (0.64)Y ==> (0.36)Y = 400

==> Y = (1/0.36)400 = (2.78)400 = 1,111.11

The size of the multiplier is (1/0.36) = 2.78.

3.b. BS = tY - TR - G = (0.2)(1,111.11) - 100 - 200 = 222.22 - 300 = - 77.78

3.c. AD' = 320 + (0.8)[Y - (0.25)Y + 100] = 400 + (0.8)(0.75)Y = 400 + (0.6)Y

From Y = AD' ==> Y = 400 + (0.6)Y ==> (0.4)Y = 400 ==> Y = (2.5)400 = 1,000

The size of the multiplier is now reduced to 2.5.

3.d. BS' = (0.25)(1,000) - 100 - 200 = - 50

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 BS' - BS = - 50 - (-77.78) = + 27.78

The size of the multiplier and equilibrium output will both increase with an increase in the
marginal propensity to consume. Therefore income tax revenue will also go up and the budget
surplus should increase.

3.e. If the income tax rate is t = 1, then all income is taxed. There is no induced spending and
equilibrium income only increases by the change in autonomous spending, that is, the size of the
multiplier is 1.

From Y = C + I + G ==> Y = Co + c(Y - 1Y + TRo) + Io + Go

==> Y = Co + cTRo + Io + Go = Ao

4. In Problem 3.d. we had a situation where the following was given:

Y = 1,000, t = 0.25, G = 200 and BS = - 50.

Assume now that t = 0.3 and G = 250 ==>

AD' = 50 + (0.8)[Y - (0.3)Y + 100] + 70 + 250 = 370 + (0.8)(0.7)Y + 80 = 450 + (0.56)Y.

From Y = AD' ==> Y = 450 + (0.56)Y ==> (0.44)Y = 450

==> Y = (1/0.44)450 = 1,022.73

BS' = (0.3)(1,022.73) - 100 - 250 = 306.82 - 350 = - 43.18

BS' - BS = -43.18 - (-50) = + 6.82

The budget surplus has increased, since the increase in tax revenue is larger than the increase in
government purchases.

5.a. While an increase in government purchases by ∆G = 10 will change intended spending by ∆Sp = 10,
a decrease in government transfers by ∆TR = -10 will change intended spending by a smaller amount,
that is, by only ∆Sp = c(∆TR) = c(-10). The change in intended spending equals ∆Sp = (1 - c)(10) and
equilibrium income should therefore increase by

∆Y = (multiplier)(1 - c)10.

5.b. If c = 0.8 and t = 0.25, then the size of the multiplier is

α = 1/[1 - c(1 - t)] = 1/[1 - (0.8)(1 - 0.25)] = 1/[1 - (0.6)] = 1/(0.4) = 2.5.

The change in equilibrium income is

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 ∆Y = α(∆Ao) = α[∆G + c(∆TR)] = (2.5)[10 + (0.8)(-10)] = (2.5)2 = 5

5.c. ∆BS = t(∆Y) - ∆TR - ∆G = (0.25)(5) - (-10) - 10 = 1.25

Additional Problems:

1. "An increase in the marginal propensity to save increases the impact of one additional dollar in
income on consumption." Comment on this statement. In your answer discuss the effect of such
a change in the mps on the size of the expenditure multiplier.

The fact that the marginal propensity to save (1 - c) has risen implies that the marginal propensity to
consume (c) has fallen. This means that now one extra dollar in income earned will affect consumption by
less than before the reduction in the mpc. When the mpc is high, one extra dollar in income raises
consumption by more than when the mpc is low. If the mps is larger, then the expenditure multiplier will
be larger, since the expenditure multiplier is defined as 1/(1-c).

2. Using a simple model of the expenditure sector without any government involvement, explain
the paradox of thrift that asserts that a desire to save may not lead to an increase in actual
saving.

The paradox of thrift occurs because the desire to increase saving leads to a lower consumption level. But
a lower level of spending sends the economy into a recession and we get a new equilibrium at a lower
level of output. In the end, the increase in autonomous saving is exactly offset by the decrease in
induced saving due to the lower income level. In other words, the economy is in equilibrium when S =
Io. Since the level of autonomous investment (Io) has not changed, the level of saving at the new
equilibrium income level must also equal Io.
This can also be derived mathematically. Since an increase in desired saving is equivalent to a
decrease in desired consumption, that is, ∆Co = -∆So, the effect on equilibrium income is

∆Y = [1/(1 - c)](∆Co) = [1/(1 - c)](-∆So).

Therefore the overall effect on total saving is

∆S = s(∆Y) + ∆So = [s/(1 - c)](-∆So) + ∆So = 0, since s = 1 - c.

3. "When aggregate demand falls below the current output level, an unintended inventory
accumulation occurs and the economy is no longer in an equilibrium." Comment on this
statement.

If aggregate demand falls below the equilibrium output level, production exceeds desired spending. When
firms see an unwanted accumulation in their inventories, they respond by reducing production. The level

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of output falls and eventually reaches a level at which total output equals desired spending. In other
words, the economy eventually reaches a new equilibrium at a lower value of output.

4. For a simple model of the expenditure sector without any government involvement, derive the
multiplier in terms of the marginal propensity to save (s) rather than the marginal propensity
to consume (c). Does this formula still hold when the government enters the picture and levies
an income tax?

In the text, the expenditure multiplier for a model without any government involvement was derived as

α = 1/(1 - c).

But since the marginal propensity to save is s = 1 - c, the multiplier now becomes α = 1/s = 1/(1-c).

In the text, we have also seen that if the government enters the picture and levies an income tax, then the
simple expenditure multiplier changes to

α = 1/[1 - c(1 - t)] = 1/(1 - c').

By substituting s = 1 - c, this equation can be easily manipulated, to get

α’ = 1/[1 - c + ct] = 1/[s + (1 - s)t] = 1/s'.

Just as s = 1 – c, we can say that s' = 1 - c', since

s' = 1 - c' = 1 - c(1 - t) = 1 - c + ct = s + (1 - s)t.

This can also be derived in another way:

S = YD - C = YD - (C* + cYD) = - C* + (1 - c)YD = - C* + sYD

If we assume for simplicity that TR = 0 and NX = 0, then

S + TA = I + G ==> - C* + sYD + TA = I* + G* ==>

s(Y - tY - TA*) + tY + TA* = C* + I* + G* ==>

[s + (1 - s)t]Y = C* + I* + G* - (1 - s)TA* = A* ==>

Y = (1/[s + (1 - s)t])A* = (1/s')A*.

5. The balanced budget theorem states that the government can stimulate the economy without
increasing the budget deficit if an increase in government purchases (G) is financed by an
equivalent increase in taxes (TA). Show that this is true for a simple model of the expenditure
sector without any income taxes.

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If taxes and government purchases are increased by the same amount, then the change in the budget
surplus can be calculated as

∆BS = ∆TAo - ∆G = 0, since ∆TAo = ∆G.

The resulting change in national income is

∆Y = ∆C + ∆G = c(∆YD) + ∆G = c(∆Y - ∆TAo) + ∆G

= c(∆Y) - c(∆TAo) + ∆G = c(∆Y) + (1 - c)(∆G) since ∆TAo = ∆G.

==> (1 - c)(∆Y) = (1 - c)(∆G) ==> ∆Y = ∆G

In this case, the increase in output (Y) is exactly of the same magnitude as the increase in government
purchases (G). This occurs since the decrease in the level of consumption due to the higher lump sum tax
has exactly been offset by the increase in the level of consumption caused by the increase in income.

6. Assume a model without income taxes and in which the only two components of aggregate
demand are consumption and investment. Show that, in this case, the two equilibrium
conditions Y = C + I and S = I are equivalent.

We can derive the equilibrium value of output by setting actual income equal to intended spending, that
is,

Y = C + I ==> Y = C* + cY + I* ==> (1 - c)Y = C* + I* ==> Y = [1/(1 - c)](C* + I*) = [1/(1 - c)]A*.

But since S = YD - C = Y - [C* + cY] = - C* + (1 - c)Y,

we can derive the same result from

S = I* ==> S = - C* + (1 - c)Y = I*

==> (1 - c)Y = C* + I* ==> Y = [1/(1 - c)](C* + I*) = [1/(1 - c)]A* .

7. In an effort to stimulate the economy in 1976, President Ford asked Congress for a $20 billion
tax cut in combination with a $20 billion cut in government purchases. Do you consider this a
good policy proposal? Why or why not?

This is not a good policy proposal. According to the balanced budget

theorem, equal decreases in government purchases and taxes will decrease
rather than increase income. Therefore the intended result would not be
achieved.

8. Assume the following model of the expenditure sector:

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 Sp = C + I + G + NX C = 420 + (4/5)YD YD = Y - TA + TR TA = (1/6)Y
TRo = 180 Io = 160 Go = 100 NXo = - 40
(a) Assume the government would like to increase the equilibrium level of income (Y) to the
full-employment level Y* = 2,700. By how much should government purchases (G) be
changed?
(b) Assume we want to reach Y* = 2,700 by changing government transfer payments (TR)
instead. By how much should TR be changed?
(c) Assume you increase both government purchases (G) and taxes (TA) by the same lump sum
of ∆G = ∆TAo = + 300. Would this change in fiscal policy be sufficient to reach the full-
employment level of output at Y* = 2,700? Why or why not?
(d) Briefly explain how a decrease in the marginal propensity to save would affect the size of the
expenditure multiplier.

a. Sp = C + I + G + NX = 420 + (4/5)[Y - (1/6)Y + 100] + 160 + 180 - 40

= 720 + (4/5)(5/6)Y + 80 = 800 + (2/3)Y

From Y = Sp ==> Y = 800 + (2/3)Y ==> (1/3)Y = 800 ==>Y = 3*800 = 2,400

==> the expenditure multiplier is α = 3

From ∆Y = α(∆Ao) ==> 300 = 3(∆Ao) ==> (∆Ao) = 100

Thus government purchases should be changed by ∆G = ∆Ao = 100.

b. Since ∆Ao = 100 and ∆Ao = c(∆TRo) ==>100 = (4/5)(∆TRo) ==> ∆TRo = 125.

c. This is a model with income taxes, so the balanced budget theorem does not apply in its strictest
form, which states that an increase in government purchases and taxes by a certain amount increases
national income by that same amount, leaving the budget surplus unchanged. Here total tax revenue
actually increases by more than 100, since taxes are initially increased by a lump sum of 100, but then
income taxes also change due to the change in income. Thus income does not increase by ∆Y = 300,
as we can see below.

∆Y = α(∆G) + α(-c)(TAo) = 3*300 + 3*[-(4/5)300] = 900 - 720 = 180

This change in fiscal policy will increase income by only ∆Y = 180, from Y0 = 2,400 to Y1 = 2,580,
and we will be unable to reach Y* = 2,700.

d. If the marginal propensity to save decreases, people spend a larger portion of their additional
disposable income, that is, the mpc and the slope of the [C+I+G+NX]-line increase. This will lead to
an increase in the expenditure multiplier and equilibrium income.

9. Assume a model with income taxes similar to the model in Problem 9 above. This time,
however, you have only limited information about the model, that is, you only know that the
marginal propensity to consume out of disposable income is c = 0.75, and that total autonomous

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 spending is Ao = 900, such that Sp = Ao + c'Y = 900 + c'Y. You also know that you can reach the
full-employment level of output at Y* = 3,150 by increasing government transfers by a lump
sum of ∆TR = 200.
(a) What is your current equilibrium level?
(b) Is it possible to determine the size of the expenditure multiplier with the information you
have?
(c) Assume you want to change the income tax rate (t) in order to reach the full-employment level of
income Y* = 3,150. How would this change in the income tax rate affect the size of the
expenditure multiplier?

a. Since ∆A = c(∆TR) = (0.75)200 = 150,

the new [C+I+G+NX]-line is of the form Sp1 = 1,050 + c1Y.
For each model of the expenditure sector we can derive the equilibrium level of income by using the
following equation:

Y* = αAo = 1/(1-c’) ==> 3,150 = α1,050 ==> the expenditure multiplier is α = 3.

If we now change autonomous spending by ∆A = 150, then income will have to change by

∆Y = α(∆A) ==> ∆Y = 3*150 = 450.

Therefore the old equilibrium level of income must have been Y = 3,150 - 450 = 2,700.

b. From our work above we can see that the size of the multiplier is α = 3.

c. The new [C+I+G+NX]-line is of the form Sp 2 = 900 + c2Y. This new intended spending line intersects
the 45-degree line at Y = 3,150. Thus the slope of the new intended spending line can be derived as

c2 = (3,150 - 900)/(3,150) = 5/7.

From Y = Sp2 ==> Y = 900 + (5/7)Y ==> (2/7)Y = 900 ==>
Y = (7/2)900 = (3.5)900 = 3,150.
The new value of the multiplier is 3.5

Sp Y = Sp

Sp2 = 900 +(5/7)Y

Sp1 = 900 = (2/3)Y

3,150

rise

900

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 run
0

2,700 3,150 Y

10. Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX C = 400 + (0.8)YD Io = 200 Go = 300 + (0.1)(Y* - Y)
YD = Y - TA + TR NXo = - 40 TA = (0.25)Y TRo = 50
(a) What is the size of the output gap if potential output is at Y* = 3,000?
(b) By how much would investment (I) have to change to reach equilibrium at Y* = 3,000, and
how does this change affect the budget surplus?
(c) From the model above you can see that government purchases (G) are counter-cyclical, that
is they are increased as national income decreases. If you compare this specification of G
with a constant level of G, how is the value of the expenditure multiplier affected?
(d) Assume the equation for net exports is changes such that NX o = - 40 is now NX1 = - 40 - mY,
with 0 < m < 1. How would this affect expenditure multiplier?

a. Sp = 400 + (0.8)YD + 200 + 300 + (0.1)(3,000 - Y) - 40

= 1,160 + (0.8)(Y - (0.25)Y + 50) - (0.1)Y = 1,200 + [(0.8)(0.75) - (0.1)]Y = 1,200 + (0.5)Y

Y = Sp ==> Y = 1,200 + (0.5)Y ==> (0.5)Y = 1,200 ==>Y = 2*1,200 = 2,400

The output gap is Y* - Y = 3,000 - 2,400 = 600.

b. From ∆Y = (mult.)(∆A) ==> 600 = 2(∆I) ==> ∆I = 300

BuS = TA - TR - G = (0.25)(2,400) - 50 - [300 + (0.1)(600)] = 600 - 50 - 300 - 60 = 190

BuS* = (0.25)(3,000) - 50 - 300 = 400, so the budget surplus increases by ∆BuS = 210.

c. If government purchases are used as a stabilization tool, the size of the multiplier should be lower than
if the level of government spending is fixed. In the model of the expenditure sector above, the slope
of the [C+I+G+NX]-line is c' = 0.5 compared to c" = 0.6, when government purchases were defined
as G = 300.

d. With this change, net exports decrease as national income increases. This additional leakage implies
that the size of the multiplier will decrease. In the model above, the slope of the [C+I+G+NX]-line
decreases from c' = (0.5) to c" = (0.5) - m. Therefore the expenditure multiplier will decrease from 1/
[1 - (0.5)] to 1/[1 - (0.5) + m].

11. Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX C = Co + cYD YD = Y - TA + TR TA = TAo
TR = TRo I = Io G = Go NX = NXo
(a) If a decrease in income (Y) by 800 leads to a decrease in savings (S) by 160, what is the size
of the expenditure multiplier?

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 (b) If a decrease in taxes (TA) by 400 leads to an increase in income (Y) by 1,200, how large is
the marginal propensity to save?
(c) If an increase in imports by 200 (∆NX = - 200) leads to a decrease in consumption (C) by
800, what is the size of the expenditure multiplier?

Recall that the expenditure multiplier for such a simple model can be calculated as:

α = 1/(1 - c)

a. (∆S)/(∆Y) = 1 - c = (-160)/(-800) = .2 ==> 1/(1 - c) = 1/(.2) = 5 ==> the multiplier is α = 5.

b. From (∆Y) = α[-c(∆TAo)] ==> (∆Y)/(∆TAo) = (-c)α = (-c)/(1 - c) ==>

(1,200)/(-400) = - 3 = (-c)/(1 - c) ==> -3(1 - c) = -c ==> c = 3/4

==> mps = 1 - c = 1/4 = 0.25.

c. ∆Y = ∆C + ∆NX = -800 + (-200) = - 1,000

==> c = (∆C)/(∆Y) = (-800)/(-1,000) = .8 ==> multiplier = α = 1/(1 - c) = 1/(.2) = 5

12. Explain why income taxation, the Social Security system, and unemployment insurance are
considered automatic stabilizers.

Income taxes, unemployment benefits, and the Social Security system are often called automatic
stabilizers because they reduce the amount by which output changes as a result of a change in aggregate
demand. These stabilizers are a part of the structure of the economy and therefore work without any
actual government intervention. For example, when output declines and unemployment increases. If we
had no unemployment insurance, people out of work would not receive any disposable income and then
consumption would drop significantly. But since unemployed workers get unemployment compensation,
consumption will not decrease as much. Therefore, aggregate demand may not be reduced by as much as
it would have without these automatic stabilizers.

13. Assume a simple model of the expenditure sector with a positive income tax rate (t). Show
mathematically how an increase in lump sum taxes (TAo ) would affect the budget surplus.

From BS = TA - G - TR = tY + TAo - G – TR

==> ∆BS = t(∆Y) + ∆TAo = t(mult.)(-c)(∆TAo) + ∆TAo

= t[1/(1 - c + ct)](-c)(∆TAo) + ∆TAo = ([ -(ct) + 1 - c + (ct)]/[1 - c + (ct)])(∆TAo)

= (1 - c) /[1 - c + (ct)])(∆TAo) > 0, since c < 1

In other words, a lump sum tax increase would increase the budget surplus.

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14. True or false? Why?
"A tax cut will increase national income and will therefore always increase the budget surplus."

False. Although a tax cut raises national income, not all of the increase in income is spent, nor is it
completely taxed away. Income tax revenues fall and the budget deficit rises. Assume the following
model of the expenditure sector:

Sp = C + I + G + NX I = Io
C = Co + cYD G = Go
YD = Y - TA +TR NX = NXo
TA = TAo + tY BS = TA - G - TR
TR = TRo

From Y = Sp ==> Y = Co + c(Y - TAo - tY + TRo) + Io + Go + NXo ==>

Y = Co - cTAo + cTRo + Io + Go + NXo + c(1 - t)Y = Ao + c'Y ==>

Y = [1/(1 - c')]Ao with c' = c (1- t)

Thus ∆Y = [1/(1 - c')][(-c)(∆TAo)]

and ∆BS = t(∆Y) + (∆TAo) = {[t(-c)]/(1 - c') + 1}(∆TAo) ==>

= {[-(ct) + 1 - c + (ct)]/[1 - c + (ct)]}(∆TAo) = {(1 - c)/[1 - c + (ct)]}(∆TAo) > 0 if ∆TA > 0.

Therefore, if taxes fall, that is, if ∆TA < 0, the budget surplus decreases.
15. Assume a simple model of the expenditure sector with a positive income tax rate (t). Show
mathematically how a decrease in autonomous investment (Io ) would affect the budget surplus.

A decrease in autonomous investment (Io) will have a multiplier effect and will therefore decrease
national income and tax revenue. The budget surplus will decrease as shown below:

∆BS = t(∆Y) = tα(∆Io) < 0

16. "An increase in government purchases will always pay for itself, as it raises national income and
hence the government's tax revenues." Comment on this statement.

An increase in government purchases will increase the budget deficit. If we assume a model of the
expenditure sector with income taxes, then the multiplier equals [1/(1 - c')] with c' = c (1- t). The change
in the budget surplus that arises from a change in government purchases can be calculated as

∆BS = t(∆Y) - ∆G = t[1/(1 - c')](∆G) - ∆G = {[t - 1 + c - (ct)]/[1 - c + (ct)]}(∆G)

= - {[(1 - c)(1 - t)]/(1 - c + (ct)]}(∆G) < 0, sine ∆G > 0.

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Therefore, if government purchases are increased, the budget surplus will decrease.

17. Is the size of the actual budget surplus always a good measure for determining fiscal policy?
What about the size of the full-employment budget surplus?

The actual budget surplus has a cyclical and a structural component. The cyclical component of the
budget surplus changes with changes in the level of income whether or not any fiscal policy measure has
been implemented. This implies that the actual budget surplus also changes with changes in income and is
therefore not a very good measure for assessing fiscal policy. The structural (full-employment) budget
surplus is calculated under the assumption that the economy is at full-employment. It therefore changes
only with a change in fiscal policy and is a much better measure for fiscal policy than the actual budget
surplus. One should keep in mind, however, that the balanced budget theorem implies that the
government can stimulate national income by an equivalent and simultaneous increase in taxes and
government purchases, thereby affecting the actual or the full-employment budget surplus.

18. Assume a model of the expenditure sector with income taxes, in which people who pay taxes,
have a higher marginal propensity to consume than people who receive government transfers,
and the consumption function is of the following form: C = Co + c(Y - TA) + dTR, with c < d.
(a) What will happen to the equilibrium level of income and the budget surplus if government
purchases are reduced by the same lump sum amount as taxes?
(b) What will happen to the equilibrium level of income and the budget surplus if government
transfers are reduced by the same lump sum amount as taxes?

a. Assume that ∆TAo = ∆G = - 100 ==>

∆Y = [(-c)/(1 - c')(∆TAo) + [1/(1 - c')](∆G) = [(1 - c)/(1 - c')](-100) < 0 c' = c(1 - t)
National income would decrease.

∆BS = t(∆Y) + ∆TAo - ∆G = t(∆Y) < 0

The budget surplus would decrease by the loss in income tax revenue.

b. Assume that ∆TAo = ∆TRo = - 100 ==>

∆Y = [(-c)/(1 - c')](∆TAo) + [d/(1 - c')](∆TRo) = [(d - c)/(1 - c')](-100) < 0 c' = c(1 - t)

National income would increase.

∆BS = t(∆Y) + ∆TAo - ∆TRo = t(∆Y) < 0

The budget surplus would decrease.

19. True or false? Why?

"The higher the marginal propensity to import, the lower the size of the multiplier."

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True. Imports represent a leakage out of the income flow. An increase in autonomous spending will raise
income and we will see the usual multiplier effect. However, if imports are positively related to income,
this effect is reduced since higher imports reduce the level of domestic demand.

Closed Economy Model Open Economy Model

Sp =C+I+G Sp = C + I + G + NX
C = Co + cY C = Co + cY
G = Go G = Go
I = Io I = Io
NX = NXo - mY with m > 0

From Y = Sp ==>

Y = (Co + Io + Go) + cY Y = (Co + Io + Go + NXo) + (c - m)Y

Y = Ao + cY Y = Ao + (c - m)Y

Y = [1/(1 - c)]Ao Y = [1/(1 - c + m)]Ao

Therefore the multiplier is defined as

[1/(1 - c)] [1/(1 - c + m)]

Clearly the open economy multiplier falls short of the closed economy multiplier. This is because
leakages reduce demand. If income taxes were included in these models, they too would reduce the
multipliers, as income taxes represent another leakage from the income flow.

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